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ECB cuts rates to record low on recession fears

The European Central Bank cut interest rates by a quarter of a point on Thursday to counter the twin threats of recession and deflation in the euro zone, and is expected to unveil fresh measures to help banks hurt by the bloc's debt crisis.

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The widely expected rate cut, back to a record low of 1 percent, came hours before a high-stakes EU summit which will aim to agree on a plan to defuse the crisis, with France and Germany pushing for rule changes to stricter budget discipline in the bloc.

The ECB, which euro zone officials say has been closely involved in drafting plans for tighter fiscal integration in the bloc, has pressed governments to toughen their budget rules and signalled it could do more to tackle the crisis if they deliver.

ECB President Mario Draghi hinted last week the bank could take stronger action - maybe by buying euro zone government bonds more aggressively - if European leaders agree on tighter budget controls.

The rate cut was aimed at buoying the euro zone economy, which economists expect to slide into recession by early 2012. The euro edged higher after the decision and the benchmark index of European stocks pared gains.

A Reuters survey of 73 analysts had showed a 60 percent chance the ECB would cut rates by 25 basis points for the second month running, back to the record low of 1.0 percent it reached during the financial crisis in 2009.

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"No surprise. This was the easy bit," Berenberg bank economist Holger Schmieding said of the rate cut.

"Standard monetary policy, including all the things they may announce to support banks, is of secondary importance," he added. "The only thing that really matters is whether or not they step up their efforts to contain the sovereign crisis."

Attention now shifts to Draghi's 1330 GMT news conference, at which he will present revised in-house economic forecasts that are expected to show the euro zone is teetering on the brink of recession.

The Italian, who took the ECB helm last month, is also expected to present new measures to aid banks hit by the crisis.

Sources have told Reuters the ECB is likely to start offering banks funding for two or even three years for the first time ever, to try to prevent the euro zone crisis precipitating a credit crunch that chokes the bloc's economy.

Policymakers will have had to decide whether the bank should charge a premium for the funding or allow the cost to track its headline rate as in other operations.

The ECB is also expected to make it easier for banks to get its funding by further expanding the menu of assets they can swap for ECB loans, something Draghi has hinted at by saying the bank is aware of the funding difficulties some banks are facing.

The ECB has already reinstated some of its most potent crisis-fighting tools in recent months in a bid to calm escalating tensions in bank-to-bank lending markets. Last week it, the U.S. Federal Reserve and a clutch of other top central banks slashed the cost of the dollar loans they offer banks.

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Perhaps the most intense focus will be on what the ECB signals it is prepared to do regarding its bond purchases.

France and Italy but also the United States and Britain have all put intense pressure on the ECB to use its potentially unlimited firepower to calm the euro zone's crisis which is now casting a dark cloud over the global economy.

Earlier this week ratings agency S&P warned that its threat of a mass downgrade of euro zone members would be tough to avoid if larger ECB bond buying was not part of Friday's summit deal.

Pressure is getting ever more intense on the central bank to avert a euro zone meltdown.

A senior euro zone source said hours before the start of the EU summit that a proposal to give the euro zone's permanent bailout fund, the European Stability Mechanism, a banking licence - which could allow it to access ECB funds, boosting its firepower - had been rejected.

The ECB had been uncomfortable about the idea but the jettisoning of another proposal that could have put a firewall around euro zone debt strugglers puts it ever more firmly in the spotlight to act directly.

However, with the summit just round the corner Draghi is expected to remain deliberately vague at his news conference.

Goldman Sachs, whose European economists are now headed by Huw Pill, a top ECB official until earlier this year, doubts the ECB will set a ceiling above which they would not allow Italian and other strained euro members' borrowing costs to go.

"We expect the ECB to move progressively towards more proactive purchases on a larger scale. But any such actions will fall short of attempts to 'cap spreads'," Pill said in a note.

With the euro zone in such turmoil, the ECB may also signal that cutting rates below 1.0 percent is no longer a taboo.

Draghi reinforced expectations for a rate cut last week when he warned the euro zone's economy was deteriorating and stressed the bank would fight deflation as aggressively as it does inflation. (Reporting by Marc Jones/Paul Carrel; editing by Mike Peacock)